The US Federal Reserve (Fed) left interest rates unchanged today, according to its policy statement, noting that it remains concerned about growth, inflation and global financial and economic developments. It, did, however, leave open the possibility of action at its June meeting. Today's outcome did not surprise investors, but the Fed's overall dovish tone in recent months may be puzzling to some.

Recent US data have pointed to moderate growth, inflation has generally surprised to the upside and the US labor market continues to improve at a healthy pace. Investors might have expected this positive economic picture plus a recovery in global financial conditions to have resulted in a more hawkish policy tone. In fact, such a view was summed up in a recent speech by Fed Vice Chair Stanley Fischer

… a persistent large overshoot of our employment mandate would risk an undesirable rise in inflation that might require a relatively abrupt policy tightening, which could inadvertently push the economy into recession.1

According to traditional thinking, the so-called Phillips Curve relationship argues that increased levels of employment should translate into wage pressures and thus higher rates of inflation, as workers negotiate higher wages. This is a view common among Fed policymakers and was evident in the Fed's economic projections published at its December Federal Open Market Committee (FOMC) meeting. The committee's projections for 2016 showed a modest increase in growth expectations from 2.1% to 2.4%, a 0.3% drop in the unemployment rate to 4.7% and a pick-up in core inflation to 1.6% from a previous forecast of 1.3%.2 Against this backdrop, FOMC members had expected a 1% rise in the target federal funds (policy) interest rate in 2016. However, although core inflation now sits above the Fed's 1.6% projection (currently 1.68%) and growth is in line with the FOMC's upgraded projections, current Fed rhetoric does not suggest an urgency to pursue policy normalization.3

Given the positive economic backdrop, we would expect a more hawkish stance if the Fed believed the Phillips Curve relationship was still intact. Instead, amid lingering concerns over China and commodity prices, for example, it appears the Fed has shifted its focus from the Phillips Curve to concerns around global financial conditions. Weighting tighter financial conditions more heavily than the rising strength in inflation implies that the Fed is taking a stance that is more in line with "optimal control" - the policy framework in which inflation may be allowed to run a little higher than warranted for a time, given the level of unemployment. In other words, rather than reacting pro-actively to rising inflation, optimal control supports overshooting inflation temporarily to reach a higher level of employment. In the current situation, the Fed appears to be applying this concept to financial conditions - in other words, allowing inflation to build while allowing global financial conditions to ease and uncertainty to recede.

Invesco Fixed Income believes the Fed's dovish stance provides a window for risk asset outperformance. While we believe valuations are fair in selected asset classes, we still see compelling opportunities in high yield, emerging markets and investment grade. Demand remains robust across fixed income risk assets as capital flows return to the market. However, we are watching for several catalysts that could reverse this "risk-on" sentiment.

First, a resumption of Chinese capital outflow pressures could result in tightening financial conditions, as we experienced earlier this year, weighing on risk assets.

Second, market perceptions that the Fed is behind the curve driven by expectations of higher inflation and further interest rate hikes could result in a shock to rates and a subsequent risk-off scenario.

Finally, a reversal in the Fed's rhetoric towards inflation concerns rather than financial conditions could negatively affect bond markets.

Sources

federalreserve.gov, Feb. 1, 2016.

federalreserve.gov, Dec. 16, 2015.

federalreserve.gov, March 16, 2016.

The fed funds rate is the rate at which banks lend balances to each other overnight.

The Federal Open Market Committee (FOMC) is a 12-member committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.

Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating.

Junk bonds involve a greater risk of default or price changes due to changes in the issuer's credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.